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The newest trend in the world of blockchain technology and cryptocurrencies has been the rise of Non-Fungible Tokens (NFTs). Over the past year, the NFT market has exploded with sales exceeding $20 billion.1 NFTs are cryptographic certificates of ownership that represent something unique, such as a piece of art, image, video, or any other real-world asset.2 Unlike NFTs, Bitcoin, Ethereum and other cryptocurrencies and tokens are fungible, meaning they can be replaced or exchanged with one another because their value defines them rather than their unique properties. NFTs, on the other hand, are unique and not mutually interchangeable, which means no two NFTs are the same.3 NFTs expand upon the notion of non-fungibility by leveraging blockchain technology to represent tokenized assets, creating new revenue streams and new ways of interacting with consumers. While digital artwork is currently the most common NFT use case, many believe that current technological developments could lay the groundwork for expansion into a variety of other tokenized property rights.
How do NFTs work?
NFTs are digital assets that reside on a blockchain platform, like Ethereum, Cardano, or Solana. The blockchain traces the ownership and transaction history of each NFT, which has a 1-of-1 token Id, and other metadata that guarantees that it’s a one-of-a-kind asset, owned by a specific crypto wallet address.4 At the basic level, NFT metadata is a JSON document that contains the name and description of the NFT, its traits, and a URL link that hosts the image. The actual NFT isn’t stored on any blockchain because, at the moment, Ethereum (and other blockchains) are slow and inefficient at storing digital data. NFTs are minted by their creator through smart contracts that verify ownership and manage the transferability of the token. NFT marketplaces, like OpenSea and Rarible, allow users to list, buy, and sell their tokenized assets.5 To mint an NFT, users have to set up a digital wallet, choose an NFT marketplace, and upload their digital files to the platform. To send or assign an NFT, the owner sends the NFT to another user’s public address and then signs the transaction with their own private key. The private key records the change in ownership of the digital item in the blockchain.
Bored Apes, CryptoPunks, and Tokenization
Digital art, in the form of JPEGs, have so far been the major use-case of NFTs. Bored Apes and CryptoPunks, a series of NFT profile pictures minted on the Ethereum blockchain, are the two most valuable NFT collections.6 In January of this year, Bored Ape #232 sold for $2.85 million in Ethereum.7 In February, CryptoPunk #5822 sold for $24 million in Ethereum.8 Celebrities and athletes have also jumped on the NFT bandwagon and profited from their individual creativeness. For example, Jack Dorsey, the ex-CEO of Twitter, tokenized his first-ever tweet and sold it as an NFT for $2.9 million.9 A digital artist who goes by Beeple sold a digital image as an NFT for $69.3 million.10 NBA’s Top Shot, a blockchain-based platform that allows fans to buy, sell and trade officially-licensed game highlights, has generated over $230 million in gross sales. Some cryptopreneurs believe that these use cases are just a starting point and that NFTs will move beyond speculation, toward real-world application.
NFTs could be used to transfer land deeds and act as a proof of ownership in property. One of the biggest hassles in real estate is the transfer of ownership as it takes tremendous amount of paperwork and time to buy a property. NFTs have the potential to streamline this process by verifying ownership and recording the deed on the blockchain at a fraction of the time. A token representing the piece of property would include the location, price, and measurements in its metadata. A similar transaction took place recently as a house in Florida, owned by an LLC, sold as an NFT for $654, 309.60 USD in Ethereum.11 The new owner not only has rights to the physical property, but also to the digital non-fungible token representing his home. The transfer of ownership took just minutes, without the need for all the paperwork.
What are the Legal Implications Surrounding NFTs?
NFTs pose an array of legal challenges, including ownership rights, copyright issues, regulatory challenges, and taxation.
NFT’s create a whole host of issues in terms of ownership, including whether the digital purchase will confer legal ownership through the traditional channels. In other words, does a blockchain transaction create a legally binding contractual relationship between a buyer and seller? Laws across the US and state municipalities have not caught up with this technology so points of sale on the blockchain are not legally enforceable yet. Therefore, buying an NFT might not mean much in the real world unless standard paperwork is handled alongside the digital sale. To circumvent this issue, it wasn’t actually the house that was sold as an NFT in the above example. The ownership of the property was first transferred to an LLC via traditional means, and then the LLC was tokenized and sold as an NFT. In the current legal system, title deeds cannot be directly represented by a token, but legal entities can. Because the LLC held the title to the property, there was no need to record the title in the county.
Distinguishing NFTs From Copyrights
Another issue that presents itself surrounds the rights that buyers acquire when they invest in an NFT. While most buyers believe that they are purchasing the work itself, and all of its accompanying rights, that is simply not the case. Again, most NFTs are just metadata files that describe the NFT and provide a link as to its whereabouts on a select server. In most cases, that is exactly what the investor is purchasing – a metadata file and a string of letters and numbers. Because the NFT and the underlying asset are two separate digital assets, the artist who minted the NFT still owns the copyright, unless those rights have also been transferred through the smart contract. On their website, NBA Top Shot advertises that “NBA Top Shot is your chance to own, sell, and trade official digital collectibles NFTs of the NBA and WNBA’s grates plays and players.”12 However, when you read their terms of service, you learn that the NFT doesn’t convey any ownership rights of NBA highlights to the purchaser, rather, a limited license to view the video on their website.13 Further, the fine print provides that if you do anything to violate their terms, NBA Top Shot will “immediately suspend or terminate your user account and/or delete your Moments’ images and descriptions from the App.”14 In other words, the purchaser doesn’t own much.
Will There Be Financial Regulations for NFTs?
NFTs are a new digital asset class; the regulatory frameworks is still under development. Due to their unique nature, NFTs are challenging to classify and depending on their classification will depend on who regulates NFTs. NFTs can trigger a range of laws including, securities laws, commodities laws, anti-money laundering and more. NFT’s can be deemed a security if they pass the scrutiny of the tenured “Howey Test.”15 Hester Pierce, SEC commissioner, has made it known there is a strong likelihood that an NFT is a security if issuers mint a fractional interest in the NFT.16 If an NFT is deemed a commodity, the Commodities Future Trading Commission (CFTC) prohibitions on deceptive and manipulative trading would apply to NFT transactions, requiring that NFTs be traded on a registered derivative exchange.17 NFTs could also be subject to US anti-money laundering requirements. In a recent study, the U.S. Treasury Department said that … [t]he digital art market, such as NFTs, may present new risks, as the characteristics of digital art make it vulnerable to money laundering.18
How Will NFTs be Taxed?
The Internal Revenue Services (IRS) has not issued any guidance on the taxation of NFT’s. As a result, taxpayers must use the existing statuary and regulatory framework to determine the tax treatment of NFT transactions. The taxation of NFTs depends on several factors, including whether the seller created the NFT or whether the seller is dealer, trader, or investor.19 A creator of the NFT will have to recognize ordinary income and pay self-employment tax on the sale of the NFTs. Similarly, dealers who buy and sell NFTs in ordinary course of business will recognize ordinary income at the time of sale. If you’re an investor, any profits earned through NFT sales or trades will be taxed as property subject to capital gains tax.20
How Gordon Delic & Associates Can Help
NFTs are an exciting new asset class for investors and creators alike. Like with any new technology, it’s crucial that you understand the accompanying risks and legal implications of minting, buying, and or selling your NFTs. Attorneys at Gordon, Delic & Associates can help defend your interests, both on-chain and off. We can review the terms governing the NFT prior to your purchase, including the rights you’re acquiring and the rights that will remain with the seller. We can also ensure that you receive all tax deductions you are entitled to. If you are a fan of minting, buying, and or selling NFT’s, it might be a good time to turn your expertise into a business.
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